As corporate credit ratings fall into high yield, the WACC benefits diminish, and debt comes with additional constraints. There are also structural forces that can incentivize high yield corporates to chase upgrades to BBB. The BBB market is also currently absorbing upgrades from BB and below (known as “Rising Stars”), not just downgrades from A and above (Figure 5).įigure 5: Rising Stars to Fallen Angels ratio spiked in 2021 5 Notably, many high yield names are also converging toward BBB
5% of AAA to A industrials by market value choose to remain above BBB (for idiosyncratic management reasons or preferences)īy rating, most of these long-term names at risk of a downgrade are within the “A” bracket, indicating a significant proportion of these universes could potentially enter the BBB market sooner rather than later (Figure 4).įigure 4: Bonds at long-term downgrade risk are skewed towards single A, just above BBB 4. All AAA to A operating company utilities remain above BBB. All AAA to A financials remain above BBB. We have based these figures on the following assumptions: This leaves a sizable universe of industrials, amounting to ~$1.5trn and ~$0.7trn for the all maturity and long-dated corporate indices respectively that may yet opt for downgrades (Figure 3).įigure 3: Roughly half the broad and long-dated AAA to A market may yet opt for downgrades 4 We believe the only major sectors that will structurally opt to retain high credit ratings are financials, such as banks (whose business models are predicated on lending at higher rates than they borrow), insurance companies and operating utilities companies (given their structural debt seniority over their holding companies – which are often rated BBB). We project that roughly half of the remaining A or better universe is likely to be downgraded to BBB for the reasons noted above. Another $1.5trn may be downgraded to BBB over time The weighted average cost of capital (WACC) associated with a BBB rating has gone from the most expensive to the cheapest, if there is no associated credit distress (Figure 2).įigure 2: On average, the WACC associated with a BBB rating has gone from most expensive to cheapest 3Īs such, we do not see this trend as cause for concern from a credit risk perspective, but reflective of sensible management decisions. Therefore, we believe it makes sense for corporate capital structures to increasingly skew toward debt over equity (i.e. 
As such, the cost of debt for many firms is no longer comparable to their cost of equity – which is ~8.5% on average for S&P 500 companies 2. To demonstrate, in 2000, investment grade yields were ~7.5% to ~8% but are now ~2.1% to ~2.6%. In the 1980s, it was structurally common for large bellwether corporates to maintain AAA ratings, but a secular decline in interest rates and credit spreads has made BBB the new optimal capital structure, resulting in downgrades to BBB.
By market value, BBBs account for ~50% of the market.įigure 1: The number of issuers rated A or above is proportionately shrinking 1 The proportion of corporate investment grade issuers rated “A” or above is in long-term secular decline with BBBs increasingly dominant in both the all-maturity and long-duration credit markets (Figure 1). The AAA to A rated corporate bond market is drying up on a secular basis
Conclusion: BBB is the sweet spot, and tactically consider high yield over high ratings. BBB and BB companies are already core holdings for many investors. As a complement to BBB exposure, look to high yield over highly rated credit. BBB currently offers the deepest and most diversified universe. Notably, many high yield names are also converging toward BBB. Another $1.5trn may be downgraded to BBB over time. The AAA to A rated corporate bond market is drying up on a secular basis. We also continue to see strategic value within high yield and believe investors should consider credit strategies with the latitude to capture potential value in areas such as these. As such, we believe BBB is the structural sweet spot for credit investors, providing the deepest and most diversified corporate bond universe. 
Cyclically, an investible component of the high yield market is also migrating to BBB given the near-term outlook for Rising Stars (high yield companies upgraded to investment grade). The highly rated (AAA to A) market is migrating to BBB on a secular basis as companies take advantage of low yields to optimize their overall weighted average cost of capital (WACC). We also believe high yield, particularly rising stars, currently offers a compelling complement to BBB in a core credit allocation. The BBB market is becoming the core of the investment grade universe, a fact we believe investors should embrace.
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